Learning From The Last Rate Cycle - How Your Bank May Change

Deposit Rate Sensitivities - Cost of Funds

We are in a period of rising rates. Since December of 2015, the Fed Funds Target has increased 75 basis points (bps). This is similar to the first set of rate increases that started back in early 2004 and ended in the third quarter of 2004 where the Fed Funds Target Rate also went up 75 bps. Back then, banks increased their cost of funds a scant four basis points. For banks looking to forecast and manage their future performance, it pays to take an in-depth look at how banks reacted during the last cycle of Fed Funds rate increases and how this time might be radically different.


The History


After the initial 75 bps of rate hikes, the Federal Reserve proceeded with a series of 25 and 50 bps rate increases between 2004 and the first half of 2006. The overnight Fed Funds Target started at 1.00% in May of 2004 and rose to 5.25% by the end of June 2006 for a total of 425 bps of increase. During that time, the cost of funds at banks rose 173 bps for a period beta of approximately 41%. Of interesting note, due to industry consolidation and loan demand, this period beta is about 40% greater than period beta during the previous rate increase over 1999 when rates rose 175 bps and banks increased their cost of funds a scant 43 bps.


Going back to the 2004 – 2006 experience, after the initial 75 bps, the next 100 bps of Fed Funds movement pushed bank’s cost of funds up another 23 bps. After that, the next two 100 bps moves both increased the bank’s cost of funds up 40 bps before the Fed started to slow its rate increase. The last two rate increases by the Fed in early 2006 moved rates up 50 bps, while bank’s cost of funds increased 25 bps. Finally, as the Fed stopped, bank’s continued to compete for funds and increased another 41 bps. 

This can be seen graphically below:


Deposit Beta or Sensitivity


Looking Forward


We are not sure where rates are going to go, but we have reason to believe that deposits are more rate sensitive than they were back in 1999 and in the 2004 – 2006 period. In particular, we see the following structural differences:


Liquidity: There is more than $2 trillion (T) of liquidity parked on the Fed’s balance sheet that was not there in previous rate cycles. These are funds that are currently parked in the U.S. banking system that was not there in prior increases. If you assume at least $1T comes off the balance sheet in the next two years; this will place upwards pressure on short-term and intermediate-term rates.


Online/Mobile/Payments: The percentage of customers that now have access to their account online and via mobile has increased almost eightfold. This electronic access has increased the velocity of money, reduced switching costs and has lowered transactional expenses. Back in 2006, it took personal branch visits and more than two hours to close and then open an account at another bank. In 2017, this can be done in less than fifteen minutes from the comfort of your home. 


Online and Mobile Banking Usage


Technology Sticky: While money will flow faster between banks with technology, community banks without robust mobile and online applications will find themselves at a disadvantage to attract inexpensive deposits. As such, rates on deposits will have to be higher, and terms will have to be more attractive to be able to attract deposits away from the large national banks that have a fully digital banking platform. In addition, consider that the top 15 internet-only banks now control almost three times the deposit market share in 2017 than they did in 2006.


Specialized Banks: General purpose banks now have to compete with deposit-hungry specialty banks such as Goldman Sachs, Discover, American Express and Synchrony. These organizations financed their assets through non-deposit methods during the previous rate cycle. Now, they compete with banks for insured deposits.


Liquidity Regulation: Target regulatory liquidity ratios not only make retail deposits more valuable for large banks but also deposits that have more than a year of contractual maturities are more valuable. That means that national banks will increase completion for deposits and since longer deposits are more rate sensitive to rates than non-maturity deposits, this fact will serve to increase the deposit beta of the industry.


Deposit Regulation: While loan-to-deposit ratios are materially lower today compared to 2006, funding pressure will continue to build. Based on the last recession, regulators place more pressure on banks to have diversified funds, less wholesale deposits and a loan-to-deposit ratio of under 90%. These factors will serve to place more pressure on banks to raise core deposits in local markets.


Putting This Into Action


We have covered extensively in the past ways to limit interest rate risk and build low-cost, low-interest sensitive deposits. Consider that the deposit beta is more than double during this current 75 bps of rate movement compared to the initial 75 bps of rate movement of the last rising rate cycle and you get a sense that rates could rise and almost double the sensitivity over the next several years compared to historical performance.  With 100 to 150 bps of rate increases assumed by the futures markets, this could have a significant impact on bank performance. The higher your bank’s loan-to-deposit ratio is and/or the higher your current cost of funds are; it is likely your deposit betas are much higher than average as well.


We are not sure where rates are going to go or what the actual deposit betas will turn out to be, but we are preparing for a sharper and more severe set of deposit elasticities.